By Aruna Viswanatha and Christina Rexrode
An appeals court dealt the Obama administration a major setback
in its efforts to levy tough fines on corporations and executives,
overturning a civil mortgage-fraud case against Bank of America
Corp. tied to the financial crisis.
The court on Monday also tossed out a $1 million civil penalty
against Rebecca Mairone , a former executive at Countrywide
Financial Corp., who was one of the few individuals fined for
alleged misdeeds during the crisis.
The ruling by the Second U.S. Circuit Court of Appeals in New
York raises the bar for the government to prove fraud against
companies and individuals, weakening a weapon the Justice
Department has used to push Wall Street to agree to big mortgage
settlements.
If it stands, the three-judge panel's unanimous decision could
affect the remaining investigations into crisis-era mortgage
securities, some observers said, including those into European
lenders Royal Bank of Scotland Group PLC and UBS Group AG. The
decision also could encourage other firms to push back against
prosecutions.
The original verdict in the Bank of America case helped pave the
way for the government to reach multibillion-dollar settlements
with large banks for alleged financial-crisis misdeeds.
Representatives of the Justice Department and the Manhattan U.S.
attorney's office, which brought the case, declined to comment. A
Bank of America spokesman said the company is "pleased with the
appellate court's decision."
The ruling won't alter the nearly $45 billion in
mortgage-securities settlements the Justice Department already has
reached with the biggest U.S. banks, including J.P. Morgan Chase
& Co. and Citigroup Inc.
The court's decision is the latest in a series of high-profile
losses by government prosecutors and regulators, both in their
attempts to punish financial crimes and to expand regulations.
A 2014 appeals court ruling made it more difficult for the
government to pursue insider-trading cases, forcing prosecutors to
drop a dozen actions in the past year and a half. In March, a
federal judge overturned the government's attempt to impose
stringent new regulatory oversight on MetLife Inc. after officials
had declared the insurer a potential threat to the global financial
system.
Last year, a memo from Deputy Attorney General Sally Yates urged
prosecutors to more aggressively pursue criminal and civil
penalties against firms and executives.
The appeals court panel threw out a $1.27 billion penalty
against Bank of America over mortgages sold by its Countrywide
unit, in what had become known as the "Hustle" case.
It revolved around a civil lawsuit that U.S. attorney's office
in Manhattan filed against Bank of America in 2012. It alleged that
a precrisis Countrywide program called Hustle had generated shoddy
mortgages and then misrepresented those loans when selling them to
Fannie Mae and Freddie Mac, which had to be bailed out by the
government during the financial crisis.
The panel said the jury's findings in 2013 that the loans sold
to Fannie and Freddie were below the quality that had been promised
might be considered an "intentional breach of contract." But it
said those transgressions didn't constitute fraud, overturning the
jury verdict that had been a signature win for government officials
widely criticized for bringing few cases tied to the 2008
crisis.
Josh Rosenkranz, who represented Ms. Mairone, said the ruling
shows "this case was a massive government overreach from
inception," in which prosecutors "tried to take an allegation of
garden variety breach of contract and turn it into a fraud with
crushing and career-ending penalties."
The ruling itself is a narrow one, but it raises issues that
underpin banks' mortgage settlements in recent years. Those cases
resolved civil accusations the banks misrepresented the quality of
loans packaged into securities.
"It is challenging to prove fraud," said Brandon Garrett, a
University of Virginia law professor who has studied corporate
prosecutions. "Obviously, people don't normally come out and admit
that they know they were selling deceptive products. It's hard to
get smoking guns. And now the courts are saying, you need smoking
guns at the beginning and end of the deal."
The government could appeal the ruling to either the full
appeals court or Supreme Court.
The Justice Department employed a little-used law enacted in the
wake of the 1980s savings-and-loan crisis, the Financial
Institutions Reform, Recovery and Enforcement Act, which allows the
government to civilly prosecute fraud affecting federally insured
financial institutions.
The issue, the court said, turned on the timing of any
misstatements and whether at the time they were made, the bank or
its employees knew they were false. In this case, the panel said,
Countrywide entered into the contract to sell loans to Fannie and
Freddie long before the alleged scheme to defraud the housing
entities took place.
"Critically, the Government presented no proof at trial that any
quality guarantee was made with fraudulent intent at the time of
contract execution," the panel said. "In essence, the Government's
theory would convert every intentional or willful breach of
contract...into criminal fraud."
At a hearing in December, U.S. Appeals Judge Reena Raggi
questioned whether the government was stretching the bounds of what
constitutes fraud. "What you're asking for is a major change in how
we view breach," Judge Raggi said at the hearing.
In 2014, U.S. District Judge Jed Rakoff ruled that the bank
should pay a penalty of $1.27 billion, more than the bank had
expected. At the time, the bank was in the midst of negotiating a
far bigger mortgage-securities settlement with the Justice
Department. People close to the matter have said that Judge
Rakoff's ruling reinforced for bank executives that the government
was going to hold it accountable for misdeeds by Countrywide, which
it acquired in 2008.
That night, Bank of America CEO Brian Moynihan agreed to the
outlines of a deal on a phone call with Eric Holder, then the
attorney general, The Wall Street Journal previously reported.
Three weeks later, the $16.65 billion settlement was announced, the
biggest ever between the Justice Department and a single
company.
The Hustle penalty was relatively small compared with other
fines paid by the bank, but it was an important step in the
government's efforts to push for bigger penalties against banks
over related charges.
The charges and trial took observers deep inside Countrywide,
which has been seen as a central player in the mortgage crisis.
According to the government, the firm accepted borrowers'
applications without checking that income levels and other
information were reasonable. It awarded bonuses to employees who
could make the case that a loan deemed defective by corporate
auditors was in fact eligible for sale to Fannie and Freddie, with
little regard for whether customers would be able to repay
them.
Ed O'Donnell, a former Countrywide executive who was the
government's star witness in the trial, testified that he was
ignored when he alerted his bosses to deterioration in the quality
of the mortgage loans.
Write to Aruna Viswanatha at Aruna.Viswanatha@wsj.com and
Christina Rexrode at christina.rexrode@wsj.com
(END) Dow Jones Newswires
May 23, 2016 19:37 ET (23:37 GMT)
Copyright (c) 2016 Dow Jones & Company, Inc.
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